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Chief executive officers are demanding that their pension funds be de-risked to avoid large contribution surprises, but de-risking fundamentally means the substitution of equities for bonds—exactly when underfunded pension plans need equity-like returns to get back to full funding. Is this a Faustian bargain?
No, say some of the leading liability-driven investment (LDI) providers. “It is a question of contribution policy, and I wouldn’t call it Faustian,” says Scott McDermott, Managing Director in the Global Portfolio Solutions Group of Goldman Sachs Asset Management. “Some plan sponsors may reasonably choose to de-risk a pension plan to obtain greater certainty of future contribution requirements.” This might be a more apt choice for certain industries working under a Pension Protection Act environment, McDermott believes, particularly “plan sponsors in highly cyclical industries where poor pension investment results, leading to unexpected demands for greater contributions, are likely to occur just when the plan sponsor’s core business might be experiencing a cyclical trough and the need for conserving corporate resources is highest.”
Kim Lisella of Cutwater Asset Management agrees, noting that de-risking over a set time frame allows plan sponsors to avoid the Faustian quandary to a degree. “By employing a disciplined approach to de-risking, such as setting funded status milestones, plans remove the temptation to time unpredictable markets, such as equities or interest rates. Since the milestone plan will be executed over time, plan sponsors can allocate to fixed-income in different market environments, allowing a systematic reduction of funded status and contribution volatility.”
However, one veteran of LDI implementation is more cautious in his assessment. “One caveat for plan sponsors exploring LDI along these lines is to make absolutely sure it’s clear what trade-off you’re considering,” says Jay Vivian, former chief of the IBM retirement system. “To me, trading off the risk of contribution surprises with the risk of lower expected long-term return to the pension plan looks like a legitimate fiduciary trade-off. However, trading off the risk of contribution surprises with the risk of lower expected long-term return to the plan sponsor (and thus the plan sponsor’s P&L) is arguably not a legitimate fiduciary trade-off.” It is important to consider the funding issue from a fiduciarily correct way, Vivian claims. “The distinction may seem like a small one, but, to me, the former looks legitimate, smart, and appropriate, albeit difficult. The latter, it could be argued, could be considered to be a trade-off with one side not properly considering ‘the sole benefit of the beneficiaries’.”
Vivian asks an interesting question: If a CEO is pressuring his CIO to de-risk the plan for the sake of the company—and not solely for the sake of the plan beneficiaries—is there a risk of breaching a fiduciary duty? Time, experience—and a good ERISA lawyer, probably—will ultimately tell, but such suggestions surely provide something for the intelligent CIO to consider before he bows to management pressure and de-risks. A deal with the devil is for life, after all. —Kip McDaniel